(This is the first in a series of regular columns of interest to business readers by Stephen Poloz, vice-president and chief economist of Export Development Canada. EDC provides trade finance and risk management services to Canadian exporters and investors in about 200 markets.)

War tensions are running high. Many scenarios still appear possible, but for the time being they all seem to point to higher oil prices in the near term.

It is widely believed that higher oil prices mean higher inflation, thereby raising the risk of higher interest rates, or at least precluding more rate cuts. The European Central Bank has cited this linkage in expressing reluctance to cut interest rates, despite a weakening economy.

Stephen Poloz

Meanwhile, inflation warning lights are flashing in Canada, and higher oil prices could fuel that risk. Memories of the inflationary 1970s, which seemed to be caused by rising oil prices, are still quite vivid.

Yet the linkage between oil prices and inflation is more complex than it appears. It is obvious that higher oil prices boost consumer prices directly. There is a second, indirect impact, too, since energy costs are embedded in most other goods and services we buy.

But oil prices go up and then they go down, if only because expensive oil leads to slower economic growth and lower demand for oil. Therefore, these superficial linkages are not really the key issue for central banks.

Rather, the problem with rising oil prices is that the initial increase in inflation may be interpreted as permanent. People then extract higher wage gains from their employers in compensation, and companies go along with it if they also see the higher oil prices as permanent and believe they can pass the added costs along to the consumer.

What can emerge is an expectations-led inflationary spiral – that is, if market conditions permit it, and if central banks allow it to proceed.

Two very big “ifs”. The risk that market conditions would permit such a spiral to emerge appears to be low, given that the world has had two slow-growth years and is entering a third. Excess capacity means international competition is fierce, leading to outright deflation in some sectors.

Furthermore, every increase in the price of oil means less money available for other purchases. The world economy will slow significantly later this year if oil prices remain above $30 for a long period. In effect, oil price rises come with their own dose of anti-inflation medicine.

What if that anti-inflationary dose proves insufficient? The risk that the world’s central banks would permit such a spiral to emerge is also low. The success of inflation targeting means that inflation has been very low for a long time, and most people have come to expect that if inflation rises, the increase will be temporary.

This change in basic behaviour reduces the odds that people will behave as if the ongoing oil-induced increase in measured inflation is permanent – it is one of the long-term benefits of low inflation. It means central banks have less work to do to keep the situation contained. This is very different from the conditions that prevailed in the 1970s, when central banks had very little inflation credibility and allowed inflation pressures to cumulate.

The bottom line? This is not the 1970s. The world is now an extremely competitive place where central banks have substantial anti-inflation credibility.

Accordingly, the linkages between oil prices, inflation and interest rates should prove to be much less mechanical than in the past.

(You can reach Stephen Poloz at spoloz@edc.ca)